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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

DUKE ENERGY FIELD SERVICES, LLC

370 17th Street, Suite 900
Denver, Colorado 80202
(Address of principal executive offices)
(Zip Code)

303-595-3331
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.   Yes   x  No  o

Indicate by check mark whether the registrant is an accelerated filer as defined by Rule 12b-2 of the Act.   Yes   o  No  x

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DUKE ENERGY FIELD SERVICES, LLC
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2003

INDEX

CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS

     Our reports, filings and other public announcements may from time to time contain statements that do not directly or exclusively relate to historical facts. Such statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. You can typically identify forward-looking statements by the use of forward-looking words, such as “may,” “will,” “could,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecast” and other similar words.

     All of such statements other than statements of historical facts, including statements regarding our future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations, are forward-looking statements.

     These forward-looking statements reflect our intentions, plans, expectations, assumptions and beliefs about future events and are subject to risks, uncertainties and other factors, many of which are outside our control. Important factors that could cause actual results to differ materially from the expectations expressed or implied in the forward-looking statements include known and unknown risks. Known risks include, but are not limited to, the following:

	•		our ability to access the debt and equity markets, which will depend on general market conditions and our credit ratings for our debt obligations;
	•		our use of derivative financial instruments to hedge commodity and interest rate risks;
	•		the level of creditworthiness of counterparties to transactions;
	•		the amount of collateral required to be posted from time to time in our transactions;
	•		changes in laws and regulations, particularly with regard to taxes, safety and protection of the environment or the increased regulation of the gathering and processing industry;

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	•		the timing and extent of changes in commodity prices, interest rates, foreign currency exchange rates and demand for our services;
	•		weather and other natural phenomena;
	•		industry changes, including the impact of consolidations and changes in competition;
	•		our ability to obtain required approvals for construction or modernization of gathering and processing facilities, and the timing of production from such facilities, which are dependent on the issuance by federal, state and municipal governments, or agencies thereof, of building, environmental and other permits, the availability of specialized contractors and work force and prices of and demand for products;
	•		the extent of success in connecting natural gas supplies to gathering and processing systems;
	•		the effect of accounting policies issued periodically by accounting standard-setting bodies; and
	•		general economic conditions, including any potential effects arising from terrorist attacks, the situation in Iraq and any consequential hostilities or other hostilities.

         In light of these risks, uncertainties and assumptions, the events described in the forward-looking statements might not occur or might occur to a different extent or at a different time than we have described. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

DUKE ENERGY FIELD SERVICES, LLC
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands)

See Notes to Consolidated Financial Statements.

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DUKE ENERGY FIELD SERVICES, LLC
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(in thousands)

See Notes to Consolidated Financial Statements.

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DUKE ENERGY FIELD SERVICES, LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

See Notes to Consolidated Financial Statements.

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DUKE ENERGY FIELD SERVICES, LLC
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands)

See Notes to Consolidated Financial Statements.

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DUKE ENERGY FIELD SERVICES, LLC
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. General

     Duke Energy Field Services, LLC (with its consolidated subsidiaries, the “Company” or “Field Services LLC”) operates in the two principal segments of the midstream natural gas industry of (1) natural gas gathering, compression, treatment, processing, transportation, marketing and trading and storage; and (2) natural gas liquids (“NGLs”) fractionation, transportation, marketing and trading. Duke Energy Corporation (“Duke Energy”) owns 69.7% of the Company’s outstanding member interests and ConocoPhillips owns the remaining 30.3%.

2. Accounting Policies

     Consolidation — The Consolidated Financial Statements include the accounts of the Company and all majority-owned subsidiaries, after eliminating significant intercompany transactions and balances. Investments in 20% to 50% owned affiliates are accounted for using the equity method. Investments greater than 50% are consolidated unless the Company does not operate these investments and as a result does not have the ability to exercise control, in which case, they are accounted for using the equity method.

     These Consolidated Financial Statements reflect all normal recurring adjustments that are, in the opinion of management, necessary to present fairly the financial position and results of operations and cash flows for the respective periods. Amounts reported in the interim Consolidated Statements of Operations are not necessarily indicative of amounts expected for the respective annual periods.

     Use of Estimates — Conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes. Although these estimates are based on management’s best available knowledge of current and expected future events, actual results could be different from those estimates.

     Inventories — Inventories consist primarily of materials and supplies and natural gas and NGLs held in storage for transmission, marketing and sales commitments. Inventories are recorded at the lower of cost or market value using the average cost method. Historically, since January 2001, natural gas storage arbitrage inventories were marked to market. However, effective January 1, 2003, in accordance with the Financial Accounting Standard Board’s (“FASB”) Emerging Issues Task Force’s (“EITF”) rescission of Issue No. 98-10, “Accounting for Contracts Involved in Energy Trading and Risk Management Activities,” all gas storage inventory is now recorded at the lower of cost or market using the average cost method (see “New Accounting Standards” below).

     Accounting for Hedges and Commodity Trading and Marketing Activities — All derivatives not qualifying for the normal purchases and sales exception under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, are recorded in the Consolidated Balance Sheets at their fair value as Unrealized Gains or Unrealized Losses on Mark-to-Market and Hedging Transactions. Prior to the implementation of the remaining provisions of EITF Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and for Contracts Involved in Energy Trading and Risk Management Activities” on January 1, 2003, certain non-derivative energy trading contracts were also recorded on the Consolidated Balance Sheets at their fair value as Unrealized Gains or Unrealized Losses on Mark-to-Market and Hedging Transactions. See the Cumulative Effect of Changes in Accounting Principles section below for further discussion of the implementation of the provisions of EITF Issue No. 02-03.

     Effective January 1, 2003, in connection with the implementation of the remaining provisions of EITF Issue No. 02-03, the Company designates each energy commodity derivative as either trading or non-trading. Certain non-trading derivatives are further designated as either a hedge of a forecasted transaction or future cash flows (cash flow hedge), a hedge of a recognized asset, liability or firm commitment (fair value hedge), or a normal purchase or sale contract, while certain non-trading derivatives remain undesignated.

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     For hedge contracts, the Company formally assesses, both at the hedge contract’s inception and on an ongoing basis, whether the hedge contract is highly effective in offsetting changes in fair values or cash flows of hedged items. The Company excludes the time value of the options when assessing hedge effectiveness.

     When available, quoted market prices or prices obtained through external sources are used to verify a contract’s fair value. For contracts with a delivery location or duration for which quoted market prices are not available, fair value is determined based on pricing models developed primarily from historical and expected correlations with quoted market prices.

     Values are adjusted to reflect the credit risk inherent in the transaction as well as the potential impact of liquidating the positions held in an orderly manner over a reasonable time period under current conditions. Changes in market prices and management estimates directly affect the estimated fair value of these contracts. Accordingly, it is reasonably possible that such estimates may change in the near term.

     Commodity Trading and Marketing — A favorable or unfavorable price movement of any derivative contract held for trading and marketing purposes is reported as Trading and Marketing Net Margin in the Consolidated Statements of Operations. An offsetting amount is recorded in the Consolidated Balance Sheets as Unrealized Gains or Unrealized Losses on Mark-to-Market and Hedging Transactions. When a contract is settled, the realized gain or loss is reclassified to a receivable or payable account. Settlement has no revenue presentation effect on the Consolidated Statements of Operations.

     See the “New Accounting Standards” section below for a discussion of the implications of EITF Issue 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” on the accounting for trading activities subsequent to October 25, 2002.

     Commodity Cash Flow Hedges — The effective portion of the change in fair value of a derivative designated and qualified as a cash flow hedge is included in the Consolidated Balance Sheets as Accumulated Other Comprehensive Income (Loss) (“AOCI”) until earnings are affected by the hedged item. Settlement amounts of cash flow hedges are removed from AOCI and recorded in the Consolidated Statements of Operations in the same accounts as the item being hedged. The Company discontinues hedge accounting prospectively when it is determined that the derivative no longer qualifies as an effective hedge, or when it is no longer probable that the hedged transaction will occur. When hedge accounting is discontinued because the derivative no longer qualifies as an effective hedge, the derivative continues to be carried on the Consolidated Balance Sheets at its fair value, with subsequent changes in its fair value recognized in current-period earnings. Gains and losses related to discontinued hedges that were previously accumulated in AOCI will remain in AOCI until earnings are affected by the hedged item, unless it is no longer probable that the hedged transaction will occur, in which case, the gains and losses that were accumulated in AOCI will be immediately recognized in current-period earnings.

     Commodity Fair Value Hedges — Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge are included in the Consolidated Statements of Operations as Sales of Natural Gas and Petroleum Products and Purchases of Natural Gas and Petroleum Products, as appropriate. Changes in the fair value of the physical portion of a fair value hedge (i.e., the hedged item) are recorded in the Consolidated Statements of Operations in the same accounts as the changes in the fair value of the derivative, with offsetting amounts in the Consolidated Balance Sheets as Other Current Assets, Other Noncurrent Assets, Other Current Liabilities or Other Long Term Liabilities, as appropriate.

     Interest Rate Fair Value Hedges — The Company periodically enters into interest rate swaps to convert some of its fixed-rate long term debt to floating-rate long term debt. Hedged items in fair value hedges are marked-to-market with the respective derivative instruments. Accordingly, the Company’s hedged fixed-rate debt is carried at fair value. The terms of the outstanding swap match those of the associated debt which permits the assumption of no ineffectiveness, as defined by SFAS No. 133. As such, for the life of the swap no ineffectiveness will be recognized.

     Income Taxes — The Company is required to make quarterly distributions to Duke Energy and ConocoPhillips based on allocated taxable income. The distributions are based on the highest taxable income allocated to either

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member, with the other member receiving a proportionate amount to maintain the ownership capital accounts at 69.7% for Duke Energy and 30.3% for ConocoPhillips.

     Stock-Based Compensation — Under Duke Energy’s 1998 Long Term Incentive Plan, stock options for Duke Energy’s common stock may be granted to the Company’s key employees. The Company accounts for stock-based compensation using the intrinsic value recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB Opinion No. 25).” Since the exercise price for all options granted under those plans was equal to the market value of the underlying common stock on the date of grant, no compensation cost is recognized in the accompanying Consolidated Statements of Operations. Restricted stock grants, phantom stock awards and stock-based performance awards are recorded over the required vesting period as compensation cost, based on the market value on the date of grant. The following disclosures reflect the provisions of SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123.”

     The following table shows what earnings available for members’ interest would have been if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to all stock-based compensation awards.

     Accumulated Other Comprehensive Income (Loss) — The components of and changes in accumulated other comprehensive income (loss) are as follows:

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     Cumulative Effect of Changes in Accounting Principles — The Company adopted SFAS No. 143, “Accounting for Asset Retirement Obligations” on January 1, 2003. In accordance with the transition provisions of SFAS No. 143, the Company recorded asset retirement liabilities and a cumulative-effect adjustment of $17.4 million as a reduction in earnings. In addition, in accordance with the EITF’s October 2002 consensus on Issue No. 02-03, on January 1, 2003, the Company decreased its inventories from fair value to historical cost and recorded a $5.4 million cumulative-effect adjustment as a reduction in earnings.

     New Accounting Standards — In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 requires that certain financial instruments that could previously be accounted for as equity, be classified as liabilities in statements of financial position and initially recorded at fair value. In addition to its requirements for the classification and measurement of financial instruments in its scope, SFAS No. 150 also requires disclosures about the nature and terms of the financial instruments and about alternative ways of settling the instruments. The provisions of SFAS No. 150 are effective for all financial instruments entered into or modified after May 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after June 15, 2003. Upon adoption on July 1, 2003, the Company will reclassify its preferred members’ interest to long-term liabilities at its fair value of approximately $200 million. Future disbursements previously classified as dividends on these preferred members’ interest will be classified as interest expense.

     In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 clarifies the discussion around initial net investment, clarifies when a derivative contains a financing component, and amends the definition of an underlying to conform it to language used in FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” In addition, SFAS No. 149 also incorporates certain of the Derivative Implementation Group Implementation Issues. The provisions of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The guidance is to be applied to hedging relationships on a prospective basis. The Company does not anticipate SFAS No. 149 will have a material impact on its consolidated results of operations, cash flows or financial position.

     In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 requires an entity to consolidate a variable interest entity if it is the primary beneficiary of the variable interest entity’s activities. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity’s activities. FIN 46 is immediately applicable to variable interest entities created, or interests in variable interest entities obtained, after January 31, 2003. For those variable interest entities created, or interests in variable interest entities obtained, on or before January 31, 2003, FIN 46 is required to be applied in the first fiscal year or interim period beginning after June 15, 2003. FIN 46 may be applied prospectively with a cumulative-effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46 also requires certain disclosures of an entity’s relationship with variable interest entities. The Company has not identified any variable interest entities created, or interests in variable interest entities obtained, after January 31, 2003 and continues to assess the existence of any interests in variable interest entities created on or prior to January 31, 2003. It is reasonably possible that the Company will disclose information about variable interest entities upon the application of FIN 46, primarily as the result of investments it has in certain unconsolidated affiliates. For all of these unconsolidated affiliates, the Company believes that its maximum exposure to loss would be equal to its investment in these entities, plus its potential obligations under its guarantees of unconsolidated debt. At June 30, 2003, the Company’s total investment in, plus the value of any guaranteed debt for entities that have a reasonable possibility to be determined to be variable interest entities, was approximately $160.7 million. The Company continues to assess FIN 46 but does not anticipate that it will have a material impact on its consolidated results of operations, cash flows or financial position.

     In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which elaborates on the disclosures to be made by a guarantor about its obligations under certain guarantees issued. It

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also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The Company adopted the initial recognition and measurement provisions of FIN 45 effective January 1, 2003. Adoption of the new interpretation had no material effect on the Company’s consolidated results of operations, cash flows or financial position.

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company adopted the provisions of SFAS No. 146 for restructuring activities initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF No. 94-3, a liability for an exit cost would have been recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized.

     In June 2002, the EITF reached a partial consensus on Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” The EITF concluded that, effective for periods ending after July 15, 2002, mark-to-market gains and losses on energy trading contracts (including those to be physically settled) must be shown on a net basis in the Consolidated Statements of Operations. The Company had previously chosen to report certain of its energy trading contracts on a gross basis, as sales in operating revenues and the associated costs recorded as purchases in costs and expenses, in accordance with prevailing industry practice.

     In October 2002, the EITF, as part of their further deliberations on Issue No. 02-03, rescinded the consensus reached in Issue No. 98-10. As a result, all energy trading contracts that do not meet the definition of a derivative under SFAS No. 133, and trading inventories that previously had been recorded at fair values, must now be recorded at the lower of cost or market and are reported on an accrual basis resulting in the recognition of earnings or losses at the time of contract settlement or termination. New non-derivative energy trading contracts entered into after October 25, 2002 should be accounted for under the accrual accounting basis. Non-derivative energy trading contracts on the Consolidated Balance Sheet as of January 1, 2003 that existed at October 25, 2002 and inventories that were recorded at fair values have been adjusted to the lower of historical cost or market via a cumulative-effect adjustment of $5.4 million as a reduction to 2003 earnings. In connection with the consensus reached on Issue No. 02-03, the FASB staff observed that, effective July 1, 2002, an entity should not recognize unrealized gains or losses at the inception of a derivative instrument unless the fair value of that instrument is evidenced by quoted market prices or current market transactions.

     In October 2002, the EITF also reached a consensus on Issue No. 02-03 that, effective for periods beginning after December 15, 2002, all gains and losses on all derivative instruments held for trading purposes should be shown on a net basis in the income statement. Gains and losses on non-derivative energy trading contracts should similarly be presented on a gross or net basis in connection with the guidance in Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” Upon application of this presentation, comparative financial statements for prior periods are required to be reclassified to conform to the consensus other than for energy trading contracts that were shown on a net basis under Issue No. 98-10. Accordingly, for the three and six months ended June 30, 2003, derivative instruments that are held for trading and marketing purposes and are accounted for under mark-to-market accounting are included in Trading and Marketing Net Margin on the Consolidated Statements of Operations. For the three and six months ended June 30, 2002, Trading and Marketing Net Margin also includes the net margin on non-derivative energy trading contracts (primarily gas storage inventories and the related physical purchases and sales) that no longer qualify for net presentation after the rescission of Issue No. 98-10. The new gross versus net revenue presentation requirements had no impact on operating income or net income.

     In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the

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asset. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is then depreciated over the life of the asset. The liability increases due to the passage of time based on the time value of money until the obligation is settled. The Company adopted the provisions of SFAS No. 143 as of January 1, 2003. In accordance with the transition provisions of SFAS No. 143, the Company recorded a cumulative-effect adjustment of $17.4 million as a reduction in 2003 earnings.

     In May 2003, the EITF reached consensus in EITF Issue No. 01-08, “Determining Whether an Arrangement Contains a Lease,” to clarify the requirements of identifying whether an arrangement should be accounted for as a lease at its inception. The guidance in the consensus is designed to mandate reporting revenue as rental or leasing income that otherwise would be reported as part of product sales or service revenue. EITF Issue No. 01-08 requires both parties to an arrangement to determine whether a service contract or similar arrangement is or includes a lease within the scope of SFAS No. 13, “Accounting for Leases.” The consensus is to be applied prospectively to arrangements agreed to, modified, or acquired in business combinations in fiscal periods beginning on July 1, 2003. The Company is currently assessing the impact EITF Issue No. 01-08 will have on its consolidated results of operations, cash flows or financial position.

     Reclassifications — Certain prior period amounts have been reclassified in the Consolidated Financial Statements and notes thereto to conform to the current presentation.

3. Derivative Instruments, Hedging Activities, Credit and Risk

     Commodity price risk — The Company’s principal operations of gathering, processing, transportation, marketing and trading and storage of natural gas, and the accompanying operations of fractionation, transportation, trading and marketing of NGLs create commodity price risk exposure due to market fluctuations in commodity prices, primarily with respect to the prices of NGLs, natural gas and crude oil. As an owner and operator of natural gas processing and other midstream assets, the Company has an inherent exposure to market variables and commodity price risk. The amount and type of price risk is dependent on the underlying natural gas contracts entered into to purchase and process raw gas. Risk is also dependent on the types and mechanisms for sales of natural gas and natural gas liquid products produced, processed, transported or stored.

     Energy trading (market) risk — Certain of the Company’s subsidiaries are engaged in the business of trading energy related products and services including managing purchase and sales portfolios, storage contracts and facilities, and transportation commitments for products. These energy trading operations are exposed to market variables and commodity price risk with respect to these products and services, and may enter into physical contracts and financial instruments with the objective of realizing a positive margin from the purchase and sale of commodity-based instruments.

     Corporate economic risks — The Company enters into debt arrangements that are exposed to market risks related to changes in interest rates. The Company periodically uses interest rate lock agreements and interest rate swaps to hedge interest rate risk associated with debt. The Company’s primary goals include (1) maintaining an appropriate ratio of fixed-rate debt to total debt for the Company’s debt rating; (2) reducing volatility of earnings resulting from interest rate fluctuations; and (3) locking in attractive interest rates based on historical rates.

     Counterparty risks — The Company sells various commodities (i.e., natural gas, NGLs and crude oil) to a variety of customers. The natural gas customers include local utilities, industrial consumers, independent power producers and merchant energy trading organizations. The NGLs customers range from large, multi-national petrochemical and refining companies to small regional retail propane distributors. Substantially all of the Company’s NGLs sales are made at market-based prices, including approximately 40% of NGLs production that is committed to ConocoPhillips and Chevron Phillips Chemical LLC, under a contract with a primary term that expires on January 1, 2015. This concentration of credit risk may affect the Company’s overall credit risk in that these customers may be similarly affected by changes in economic, regulatory or other factors. On transactions where the Company is exposed to credit risk, the Company analyzes the counterparties’ financial condition prior to entering into an agreement, establishes credit limits and monitors the appropriateness of these limits on an ongoing basis. The corporate credit policy prescribes the use of master collateral agreements to mitigate credit exposure.

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The collateral agreements provide for a counterparty to post cash or letters of credit for exposure in excess of the established threshold. The threshold amount represents an open credit limit, determined in accordance with the corporate credit policy. The collateral agreements also provide that the failure to post collateral is sufficient cause to terminate a contract and liquidate all positions.

     Physical forward contracts and financial derivatives are generally cash settled at the expiration of the contract term. These transactions are generally subject to specific credit provisions within the contracts that would allow the seller, at its discretion, to suspend deliveries, cancel agreements or continue deliveries to the buyer after the buyer provides security for payment satisfactory to the seller.

     Commodity cash flow hedges — The Company uses cash flow hedges, as specifically defined by SFAS No. 133, to reduce the potential negative impact that commodity price changes could have on the Company’s earnings, and its ability to adequately plan for cash needed for debt service, dividends, capital expenditures and tax distributions. The Company’s primary corporate hedging goals include maintaining minimum cash flows to fund debt service, dividends, production replacement, maintenance capital projects and tax distributions; and retaining a high percentage of potential upside relating to price increases of NGLs.

     The Company uses natural gas, crude oil and NGLs swaps and options to hedge the impact of market fluctuations in the prices of NGLs, natural gas and other energy-related products. For the six months ended June 30, 2003, the Company recognized a net loss of $63.2 million, of which a $3.0 million gain represented the total ineffectiveness of all cash flow hedges and a $66.2 million loss represented the total derivative settlements. No derivative gains or losses were reclassified from AOCI to current period earnings as a result of the discontinuance of cash flow hedges related to any forecasted transactions that are not probable of occurring.

     Gains and losses on derivative contracts that are reclassified from AOCI to current period earnings are included in the line item in which the hedged item is recorded. As of June 30, 2003, $51.4 million of the deferred net losses on derivative instruments in AOCI are expected to be reclassified into earnings during the next 12 months as the hedge transactions occur; however, due to the volatility of the commodities markets, the corresponding value in AOCI is subject to change prior to its reclassification into earnings. The maximum term over which the Company is hedging its exposure to the variability of future cash flows is three years.

     Commodity fair value hedges — The Company uses fair value hedges to hedge exposure to changes in the fair value of an asset or a liability (or an identified portion thereof) that is attributable to price risk. The Company hedges producer price locks (fixed price gas purchases) and market locks (fixed price gas sales) to reduce the Company’s exposure to fixed price risk via swapping out the fixed price risk for a floating price position (New York Mercantile Exchange or index based).

     For the six months ended June 30, 2003, the gains or losses representing the ineffective portion of the Company’s fair value hedges were not significant. All components of each derivative’s gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted. The Company did not have any firm commitments that no longer qualified as fair value hedge items and therefore, did not recognize an associated gain or loss.

     Interest rate fair value hedge — In October 2001, the Company entered into an interest rate swap to convert the fixed interest rate of $250.0 million of debt securities that were issued in August 2000 to floating rate debt. The interest rate fair value hedge is at a floating rate based on a six-month London Interbank Offered Rate (“LIBOR”), which is re-priced semiannually through 2005. The swap meets conditions which permit the assumption of no ineffectiveness, as defined by SFAS No. 133. As such, for the life of the swap no ineffectiveness will be recognized. As of June 30, 2003, the fair value of the interest rate swap of $16.3 million was included in the Consolidated Balance Sheets as Unrealized Gains or Losses on Trading and Hedging Transactions with an offset to the underlying debt included in Long Term Debt.

     Commodity Derivatives — Trading and Marketing — The trading and marketing of energy related products and services exposes the Company to the fluctuations in the market values of traded and marketed instruments. The Company manages its traded and marketed instrument portfolios with strict policies which limit exposure to market risk and require daily reporting to management of potential financial exposure. These policies include statistical risk tolerance limits using historical price movements to calculate a daily earnings at risk measurement.

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4. Asset Retirement Obligations

     SFAS No. 143,“Accounting for Asset Retirement Obligations.” In June 2001, the FASB issued SFAS No. 143 which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset. The Company’s asset retirement obligations relate primarily to the retirement of various gathering pipelines and processing facilities, obligations related to right-of-way agreements and contractual leases for land use.

     SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is then depreciated over the life of the asset. The liability increases due to the passage of time based on the time value of money until the obligation is settled.

     The Company identified various assets as having an indeterminate life in accordance with SFAS No. 143, which do not trigger a requirement to establish a fair value for future retirement obligations associated with such assets. These assets include certain pipelines, processing plants and distribution facilities. A liability for these asset retirement obligations will be recorded if and when a future retirement obligation is identified.

     SFAS No. 143 was effective for fiscal years beginning after June 15, 2002, and was adopted by the Company on January 1, 2003. At January 1, 2003, the implementation of SFAS No. 143 resulted in a net increase in total assets of $25.1 million, consisting of an increase in net property, plant and equipment. Long term liabilities increased by $42.5 million, which represents the establishment of an asset retirement obligation liability. A cumulative-effect of a change in accounting principle adjustment of $17.4 million was recorded in the first quarter of 2003, as a reduction in earnings.

     The following table shows the asset retirement obligation liability as though SFAS No. 143 had been in effect for the prior three years.

     The asset retirement obligation is adjusted each quarter for any liabilities incurred or settled during the period, accretion expense and any revisions made to the estimated cash flows. The following table rolls forward the asset retirement obligation from the balance at December 31, 2002 to June 30, 2003.

5. Financing

     Credit Facility with Financial Institutions — On March 28, 2003, the Company entered into a new credit facility (the “Facility”). The Facility replaces the credit facility that matured on March 28, 2003. The Facility is used to support the Company’s commercial paper program and for working capital and other general corporate purposes. The Facility matures on March 26, 2004, however, any outstanding loans under the Facility at maturity may, at the Company’s option, be converted to a one-year term loan. The Facility is a $350.0 million revolving credit facility, of which $100.0 million can be used for letters of credit. The Facility requires the Company to maintain at all times a debt to total capitalization ratio of less than or equal to 53%; and maintain at the end of each

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fiscal quarter an interest coverage ratio (defined to be the ratio of adjusted EBITDA, as defined by the Facility, for the four most recent quarters to interest expense for the same period) of at least 2.5 to 1 (adjusted EBITDA, as defined by the Facility, is defined to be earnings before interest, taxes and depreciation and amortization and other adjustments); and contains various restrictions applicable to dividends and other payments to the Company’s members. The Facility bears interest at a rate equal to, at the Company’s option and based on the Company’s current debt rating, either (1) LIBOR plus 1.25% per year or (2) the higher of (a) the JP Morgan Chase Bank prime rate plus 0.25% per year and (b) the Federal Funds rate plus 0.75% per year. At June 30, 2003, there were no borrowings against the Facility.

     On March 28, 2003, the Company also entered into a $100.0 million funded short-term loan with a bank (the “Short-Term Loan”). The Short-Term Loan is used for working capital and other general corporate purposes. The Short-Term Loan matures on September 30, 2003, and may be repaid at any time. The Short-Term Loan has the same financial covenants as the Facility. The Short-Term Loan bears interest at a rate equal to, at the Company’s option, either (1) LIBOR plus 1.35% per year or (2) the higher of (a) the bank’s prime rate and (b) the Federal Funds rate plus 0.50% per year. Subsequent to June 30, 2003, the Company repaid the entire Short-Term Loan with funds generated from asset sales and operations.

6. Commitments and Contingent Liabilities

     The midstream natural gas industry has seen a number of class action lawsuits involving royalty disputes, mismeasurement and mispayment allegations. Although the industry has seen these types of cases before, they were typically brought by a single plaintiff or small group of plaintiffs. A number of these cases are now being brought as class actions. The Company and its subsidiaries are currently named as defendants in some of these cases. Management believes the Company and its subsidiaries have meritorious defenses to these cases, and therefore will continue to defend them vigorously. However, these class actions can be costly and time consuming to defend. Management believes that the final disposition of these proceedings will not have a material adverse effect on the consolidated results of operations or financial position of the Company.

7. Business Segments

     The Company operates in two principal business segments as follows: (1) natural gas gathering, compression, treatment, processing, transportation, marketing and trading and storage (“Natural Gas Segment”), and (2) NGLs fractionation, transportation, marketing and trading (“NGLs Segment”). These segments are monitored separately by management for performance against its internal forecast and are consistent with the Company’s internal financial reporting. These segments have been identified based on the differing products and services, regulatory environment and the expertise required for these operations. The following table includes the components of the performance measures used by management to monitor the business of each segment. The accounting policies for the segments are the same as those described in Note 2. Foreign operations are not material and are not separately identified.

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     The following table sets forth the Company’s segment information.